Changes to taxation of dividends

In the Summer Budget the Chancellor dropped a bombshell for owner managers of smaller companies by stating that, from April 2016, only the first £5,000 of dividends received in a tax year would be tax free (the dividend allowance). Dividends over the allowance will be taxed at 7.5% in the basic rate band, 32.5% in the higher rate band and 38.1% in the additional rate band. However, it was unclear how the £5,000 dividend allowance would interact with the different tax bands.

Dividend allowance factsheet

Thankfully, after more than a month of confusion, HMRC published a dividend allowance factsheet:

https://www.gov.uk/government/publications/dividend-allowance-factsheet/dividend-allowance-factsheet

This provides some useful examples of how dividends will be taxed in 2016/17. It also explains that the dividend allowance will still count towards the basic or higher rate bands rather than being an extra £5,000 basic rate band for dividends.

Example. In 2016/17 a director shareholder receives a salary from his company of £8,000 a year and dividends dividends of £38,000. His taxable income for the year after taking into account the £11,000 personal allowance is £35,000. As the basic rate band for 2016/17 is £32,000, he will pay tax at 0%on the first £5,000, then 7.5% on the next £27,000 and 32.5% on the remaining £3,000. So the total tax due will be £3,000. Under the old rules he would have paid no tax on the basic rate band dividends  (so he's losing out by £2,025 under the new rules) and only paid tax of £750 (£3,000 x 25%)on the higher rate  dividends  (so he's losing out by a further £225).